Indifference

Curve

Analysis

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Ordinal Utility Approach

Ordinal Utility Approach:

The basic idea behind ordinal utility approach is that a consumer keeps number of pairs of two commodities in his mind which give him equal level of satisfaction. This means that the utility can be ranked qualitatively.

The ordinal utility approach differs from the cardinal utility approach (also called classical theory) in the sense that the satisfaction derived from various commodities cannot be measured objectively.

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Ordinal theory is also known as neo-classical theory of consumer equilibrium, Hicksian theory of consumer behavior, indifference curve theory, optimal choice theory. This approach also explains the consumer's equilibrium who is confronted with the multiple objectives and scarcity of money income.

The important tools of ordinal utility are:

1. The concept of indifference curves.

2. The slop of I.C. i.e. marginal rate of substitution.

3. The budget line.

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Indifference Curve

Indifference Curve is a locus of all such points which shows different combination of two commodities which yield equal satisfaction to the consumer, so that he is indifferent to the particular combination he consumes.

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Indifference Curve schedule

It refers to a schedule that ind icates d ifferent combinat ions of two commodit ies which y ie ld equal sat isfact ion. table 1. ind ifference curve schedule

Combination of apple s and oranges

Apples Oranges

A 1 10

B 2 7

C 3 5

D 4 4

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Indifference Curve

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Indifference Map refers to a set of

Indifference Curve.

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Assumptions of

Indifference Curve Analysis:

a) Consumer is rational.

b) Utility can be measured in Ordinal numbers.

c) Marginal rate of substitution (MRS) diminishes

(marginal rate of substitution is the rate at which a consumer is ready to give up one good in exchange for another good while maintaining the same level of utility)

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d) Consumer’s behavior is Consistent. E.g. if consumer prefers A combination > B combination at one time, then at another time he will not prefer more of B combination than A combination. e) Transitivity. E.g. if consumer prefers A combination to B combination and B combination to C combination, then he will definitely prefer A combination to C combination. f) Consumer’s scale of Preference is Independent of his income and prices of goods in the market.

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1) Straight line indifference curve : In case of Perfect Substitutes, IC may be a straight line with negative slope. e.g. Taj Mahal (X-commodity) and Brooke Bond tea (Y-commodity) are perfect substitute of each other. Here,

MRSxy = 1

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2)Right-angled Indifference Curve :

In case of Perfectly Complementary goods, the shape of IC is right-Angle.

e.g. a consumer will buy right and left shoes in a fixed ratio.

Here,

MRSxy = 0

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The Budget line shows all different combinations of the two commodities that a consumer can purchase given his money income and price of two commodities.

Slope of Price line = Px/Py

Here; Px= price of apples Py = price of oranges

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Suppose ; a consumer has: Income = Rs. 4 to be spent on apples and oranges. Price of apple = Rs. 1.00 Price of oranges = Rs. 0.50 the different combinations that a consumer can get of these goods are :

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From Figure; Budget line = AB

If there is any point outside or to the right of price line AB, the consumer will not be able to buy that combination of two goods because of his limited income.

If there is any point inside or to the left of price line AB, then the consumer will be unable to spend all his income.

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Change in Income

Effect on Price Line

Rise Shift to Right

Fall Shift to Left

1) Due to change in Income:

Assumptions : o price of two goods

remain constant and o income of consumer

changes.

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2) Due to change in the Price of one commodity: Assumptions: Income of consumer

remain unchanged. Price of one commodity is

constant. Price of other commodity

changes.

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Consumer’s equilibrium refers to a situation in which a consumer with given income and given prices purchases such a combination of goods and services which gives him maximum satisfaction and he is not willing to make any change in it.

It is struck when “what he is willing to buy coincides with what he can buy”

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Prices of goods are constant.

Consumer’s income is also constant.

Consumer knows the prices of all things.

Consumer can spend his income in small quantities.

Consumer is rational.

Consumer is fully aware of Indifference map.

Perfect competition in the market.

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1) Price line should be tangent to Indifference Curve.

or

Slope of IC = Slope of Price line

or

MRSxy = Px/Py

2) Indifference Curve must be Convex to the Origin.

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When the consumer is in equilibrium, his highest attainable Indifference Curve is tangent to price line.

From Figure:

At point ‘D’, slope of Indifference Curve and Price Line coincide. Therefore, first condition of consumer’s equilibrium is satisfied.

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It means that MRS of Apples for Oranges should be diminishing. If at the point of equilibrium, Indifference Curve is Concave and not Convex to the Origin, then it will not be a position of permanent equilibrium. Therefore, a consumer will be in permanent equilibrium where both the conditions are satisfied.

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IT IS THE RATE AT WHICH THE CONSUMER IS WILLING TO GIVE UP COMMODITY Y FOR ONE MORE UNIT OF COMMODITY X IN ORDER TO MAINTAIN THE SAME LEVEL OF SATISFACTION.

UTILITY GAINED OF GOOD X=UTILITY LOST OF GOOD Y

IT IS ESTIMATED AS

MRSXY = ΔY/ΔX

ON ANY POINT ON IC.

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According to this Law, “ as a consumer gets more and more units of X , he will be willing

to give up less and less units of Y”

In other words, the marginal rate of substitution of X for Y will go on diminishing while the level of satisfaction of the consumer

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Combinations

Apples (X)

Oranges (Y)

MRS = Loss Y/ Gain X

A 1 10 _

B 2 7 3/1

C 3 5 2/1

D 4 4 1/1

Table 2. Schedule

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Table 2. indicat es that the consumer wil l give up

3 oranges for getting the second apple,

2 oranges for getting the third apple and

1 orange for getting the fourth apple.

In other words, MRS of apples for oranges goes on diminis hing .

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?

It diminishes ;

As Law of Diminishing marginal rate of substitution is an extensive form of Law of diminishing marginal utility.

According to Law of Diminishing Marginal Utility,

Consequently, consumer is willing to give up less and less units of oranges for every additional unit of apple.

Therefore, Marginal rate of substitution of apples for oranges diminishes.

As Consumption by Consumer

Marginal Utility goes on

1) Increases 1) Diminishing

2) Decreases 2) Increasing

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The marginal rate of substitution is constant if to obtain one more unit of X, only one unit of Y is sacrificed to maintain same level of satisfaction. Marginal rate of substitution of perfect substitution is constant. TABLE 3.

Combination Apples Oranges MRS= Loss Y/Gain X

A 1 10 _

B 2 9 1/1

C 3 8 1/1

D 4 7 1/1

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Indifference Curve will be a Straight line

falling downwards from left to right.

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It implies that as the stock of a commodity increases with the consumer he substitutes it for the other commodity at an increasing rate to maintain the same level of satisfaction.

Table 4.

Combinations Apples Oranges MRS= Loss Y/Gain X

A 1 10 _

B 2 9 1/1

C 3 7 2/1

D 4 4 3/1

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Indifference Curve will be

Concave to the point of origin.

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Type of goods

Price effect Income effect

Shape of Demand Curve

1) Normal Goods

Negative Positive Slopes Upward

2) Inferior Goods

Negative Negative Slopes Downward

3) Giffen’s Goods

Positive Negative Slopes Upward

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Basis of Difference

Law of Diminishing Marginal Utility

Law of Diminishing Marginal Rate of

Substitution

1) Measurement in Cardinal/Ordina

l numbers

Unrealistic assumption that marginal utility can be measured in Cardinal

numbers.

Realistic assumption that utility can be measured in

Ordinal numbers.

2) Independence of Commodities

Utility of one commodity is independent of the

utility of other commodity.

Utility of one commodity is dependent of the utility

of other commodity.

3) Marginal utility of money (MUm)

Assumption is that MUm remains constant.

No such assumption.

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